The transition away from the LIBOR interbank interest benchmark has been one long journey. Now, with only six months to go until June 2023, the end is near for the cessation of USD LIBOR.
Data produced by the Alternative Reference Rates Committee (ARRC) at its meeting on November 9, 2022, indicated that the transition from LIBOR to Secured Overnight Financing-based rates (SOFR) has progressed strongly in 2022. According to the ARRC, SOFR is now predominant across cash and derivatives markets. For the derivatives markets, “SOFR swaps have accounted for more than 90 percent of daily volumes on average of interest rate risk traded in the outright linear swaps market,” Commodity Futures Trading Commission (CFTC) Chairman Rostin Behnam confirmed in a recent speech.
In April 2021, the CME Group derivatives exchange announced publication of the Term SOFR Reference Rates benchmark. This is a daily set of forward-looking interest rate estimates calculated and published for 1m, 3m, 6m, and 12-month tenors using information from CME SOFR future contracts to establish volume-weighted average prices. The ARRC has produced best practice guidelines in relation to Term SOFR’s scope of use in new contracts. In particular for derivatives, the ARRC has recommended that any use of Term SOFR in derivatives be limited to:
- derivatives intended to hedge cash products that reference Term SOFR, and
- end users or lending institutions not making markets in derivatives.
Following recent developments in the market, the ARRC is emphasizing the need to uphold its best practice guidelines. In its November 9 meeting readout, the ARRC singled out “securitizations using Term SOFR when they did not have underlying Term SOFR assets” as falling outside the scope of its guidelines. If this practice were to begin trending, it would increase the use of Term SOFR derivatives, which could lead to a decline in the overnight SOFR derivatives markets on which Term SOFR is based. The ARRC underscored that its targeted recommendations have been “carefully calibrated to ensure the robustness and sustainability of the rate itself and avoid risks to financial stability.”
Federal Reserve Final Rule
On December 16, 2022, the Federal Reserve Board adopted the final rule implementing the LIBOR Act. As part of the final rule, the Fed confirmed the use of SOFR to replace certain tenors of USD LIBOR references (overnight, 1m, 3m, 6m, and 12-month tenors) in contracts governed by U.S. law. In particular, the final rule established clarity on benchmark replacement for tough legacy contracts—that is, contracts with no clearly defined fallback provisions and that expire beyond June 30, 2023.
As part of its final rule, the Fed maintained that different contract types warrant different benchmark replacements:
- Derivative contracts: Given significant adherence by derivative market participants to the ISDA 2020 IBOR Fallbacks Protocol and the wide usage of references to SOFR compounded in arears—and to minimize disruption to the market—the Fed selected the Fallbacks Protocol, which uses SOFR compounded in arrears plus a stated spread adjustment.
- Cash transaction contracts: The rate selected for consumer loans was CME Term SOFR plus the transition tenor spread adjustment (for the one-year period beginning on June 30, 2023) or the tenor spread adjustment specified in the LIBOR Act thereafter.
In instances where a derivative is executed as a hedge for a cash transaction, it is worth noting that both products will have different benchmark replacement rates and spread adjustments as a result. Market participants should be aware of any basis risk exposure, and consideration should be given to ensure this risk is appropriately managed throughout the repapering process.
The final rule also highlighted some specific contracts for which the fallback rate will differ, such as asset-backed securitizations composed predominantly of Federal Family Education Loan program and government-sponsored enterprises regulated by the Federal Housing Finance Agency.
In June 2022, the UK’s Financial Conduct Authority (FCA) launched a consultation to seek information on USD LIBOR exposure, market participants’ plans to transition these exposures away from LIBOR before end-June 2023, and their views on any challenges or issues that might result from the publication of any of the 1m, 3m, and 6-month USD LIBOR settings on a synthetic basis.
The feedback received by the FCA led to the conclusion that there is a case for publishing the 1m, 3m, and 6-month synthetic USD LIBOR settings until end-September 2024 as well as permitting the use of these synthetic USD LIBOR settings in all contracts except cleared derivatives.
A further consultation was launched by the FCA on November 23 to seek market views on its proposed intention to ask the ICE Benchmark Administration (IBA) to continue to:
- Publish the 1m, 3m, and 6-month USD LIBOR settings under a synthetic methodology (CME Term SOFR plus the relevant ISDA fixed spread adjustment) for a temporary period until end-September 2024; and
- Permit all legacy contracts other than cleared derivatives to use a synthetic USD LIBOR.
This consultation was to end on January 6, 2023, and the final decision is expected to be announced in late Q1 or early Q2 2023. Any published synthetic LIBOR settings are not for use in new contracts and are intended for use in tough legacy contracts only as an interim measure.
Looking Ahead in H1 2023
With the industry now firmly in the execution phase of the USD LIBOR transition, key considerations for market players include:
- The potential basis risk that market participants may be exposed to, in instances where a derivative is executed as a hedge for a cash transaction and where the derivative contract and the cash transaction could be subject to different fallback benchmark replacement rates.
- The outcome of the FCA’s consultation on synthetic USD LIBOR to understand the final methodology, particularly for derivatives where CME Term SOFR plus the relevant ISDA fixed spread adjustment is proposed.
- The continued cessation of IBOR benchmarks such as CDOR, where the Canadian Alternative Reference Rate working group has recommended cessation for June 2024.
- The potential for the International Swaps and Derivatives Association (ISDA) to expand fallback arrangements with further modules to the ISDA 2021 Fallbacks Protocol, such as the November 2022 Benchmark Module of the ISDA 2021 Fallbacks Protocol providing fallbacks for CIBOR, MosPrime, and TELBOR.
CFTC Chairman Behnam summed up the tone for the market in his November statement for Bloomberg’s The Final Chapter for USD LIBOR: “Complacency is no longer an option and market participants cannot assume that they can ride the LIBOR train until the end of the line.” He encouraged market participants to proactively make the transition to SOFR now and not leave it to the final moment.
Note: If you have any questions about how the LIBOR transition will impact your business or are looking for skilled specialists to help navigate the transition, get in touch with Phil Marsden at firstname.lastname@example.org.